Discussion Question One:
This week in our text and video lectures, we are starting to study how companies can get and record funding. There are three ways: from Liabilities, from issuing Stocks, or from Profitable Operations.
• Describe each of these three ways and indicate where on the financial statements you could find the information about each. Hint: It might be in more than one place.
• Give the advantages and disadvantages for each.
• Give an example for each and show how you would record the transaction in the accounting.
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1) Liabilities funding:
- Description: Companies can obtain funding by taking on liabilities, such as loans or issuing bonds. This means borrowing money from external sources and promising to pay it back within a given time period, along with any interest or fees.
- Financial statement location: The information about liabilities funding can be found in the balance sheet under the liabilities section. It may also be mentioned in the notes to the financial statements if there are significant loan terms or bond issuance details.
Advantages:
- Allows companies to access large amounts of capital without diluting ownership.
- Interest paid on loans is tax-deductible, reducing the overall cost of borrowing.
Disadvantages:
- Increased financial risk if the company is unable to generate enough cash flow to make loan repayments.
- High-interest rates on loans can increase the company's cost of capital and reduce profitability.
Example: Company ABC takes out a $1 million loan from a bank to finance a new manufacturing plant. The company records the transaction by debiting the cash account for $1 million (increasing assets) and crediting the loan payable account for $1 million (increasing liabilities).
2) Issuing stocks:
- Description: Companies can raise funds by issuing stocks, which represents ownership in the company. Investors purchase shares of stock, giving them a claim on the company's assets and profits.
- Financial statement location: Information about issuing stocks can be found in the balance sheet under the equity section, specifically in the common stock or additional paid-in capital accounts. The statement of changes in equity may also provide details on any stock issuances.
Advantages:
- Allows companies to raise capital without incurring debt and interest payments.
- Increases financial flexibility and potentially attracts more investors.
Disadvantages:
- Dilution of ownership as more shares are issued, which may lead to a loss of control by existing shareholders.
- Companies may become susceptible to shareholder activism or hostile takeovers.
Example: Company XYZ issues 100,000 new shares of common stock at a price of $10 per share, raising $1 million in equity funding. The company records the transaction by debiting the cash account for $1 million (increasing assets) and crediting the common stock account for $100,000 and additional paid-in capital account for $900,000 (increasing equity).
3) Funding from profitable operations:
- Description: Companies can generate funding through their profitable operations, where the cash generated from sales exceeds the expenses incurred in producing and selling goods or services.
- Financial statement location: The information about funding from profitable operations can be found in the statement of cash flows, specifically in the operating activities section, where net income is adjusted for non-cash charges and changes in working capital.
Advantages:
- Companies can fund their operations without relying on external financing, reducing interest and repayment obligations.
- Demonstrates the ability of the company to generate sustainable cash flow.
Disadvantages:
- Companies may face challenges during periods of low profitability or economic downturns, affecting their ability to generate funding from operations.
- Insufficient profitability may limit growth opportunities and investment in new projects or acquisitions.
Example: Company DEF generates $2 million in net income from its operations. The company records the transaction by debiting the retained earnings account for $2 million (increasing equity) and crediting the income statement revenue and expense accounts for the corresponding amounts (recognizing revenue and expenses).
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